PNC FINANCIAL SERVICES GROUP, INC. annual report, FY2014

Business context and reporting period

The PNC Financial Services Group, Inc. is a diversified U.S. financial services company with retail banking, corporate and institutional banking, asset management, residential mortgage banking, an equity investment in BlackRock, and a non-strategic assets portfolio. This Form 10-K covers the fiscal year ended December 31, 2014; comparative results are primarily for 2013. The financial statements received an unqualified audit opinion, and management and the auditor concluded internal control over financial reporting was effective at year-end.

Financial performance and condition

• Fourth quarter: net income was $1.057 billion and diluted EPS was $1.84, versus $1.074 billion and $1.87 in fourth-quarter 2013. Revenue was $3.947 billion; provision for credit losses was $52 million.
• Balance sheet at year-end: assets were $345.1 billion, loans $204.8 billion, deposits $232.2 billion, borrowed funds $56.8 billion, and shareholders’ equity $44.6 billion. Loans were 88% of deposits.
• Credit quality: nonperforming assets fell to $2.88 billion from $3.46 billion; net charge-offs were $531 million, or 0.27% of average loans, versus $1.077 billion, or 0.57%. The allowance for loan and lease losses was $3.331 billion, 1.63% of loans and 133% of nonperforming loans.
• Capital and liquidity: the transitional Basel III common equity Tier 1 ratio was 10.9%; estimated fully phased-in standardized-approach common equity Tier 1 was 10.0%. PNC and PNC Bank were deemed well capitalized. Year-end liquid assets were $80.2 billion; parent-company available liquidity was $7.1 billion. Estimated December 31 pro forma LCRs exceeded 100% for PNC and 95% for PNC Bank.
• Cash flows: operating activities provided $5.557 billion, investing activities used $24.893 billion, and financing activities provided $19.653 billion. Cash and due from banks increased $317 million. These bank cash flows reflect lending, securities and funding activity, not a conventional industrial-company free-cash-flow measure.

Material changes versus the prior comparable period

• Revenue declined 4%, principally because net interest income fell 7% amid low rates, lower loan and securities yields, reduced purchase-accounting accretion, and a lower average securities balance. Net interest margin contracted 49 basis points.
• Noninterest income was nearly unchanged: growth in asset management, corporate services and deposit fees was offset by lower residential mortgage revenue, lower asset valuations and fewer securities gains.
• Credit costs improved materially: provision declined 58% and net charge-offs declined 51%. Management cited better credit quality, lower consumer delinquencies and improved residential property values.
• Loans grew 5%, led by 10% growth in commercial lending; consumer loans fell 3%. Deposits increased 5%, while borrowed funds rose 23%, partly reflecting liquidity management and increased FHLB borrowings and debt issuance.
• Net income was essentially flat as lower credit provision and expenses largely offset weaker revenue. The efficiency ratio increased to 62% from 60%; return on average common equity fell to 9.91% from 10.85%.
• Segment results were mixed: Retail Banking, Asset Management Group and BlackRock earnings increased; Corporate & Institutional Banking and Residential Mortgage Banking earnings declined. Mortgage origination volume fell to $9.5 billion from $15.1 billion.

Outlook, commentary, risks and unusual items

• Management expected first-quarter 2015 net interest income to be stable versus fourth-quarter 2014; full-year 2015 purchase-accounting accretion was expected to decline about $225 million versus 2014. Full-year revenue was expected to remain under pressure, with business growth only partly offsetting lower accretion.
• For first-quarter 2015, management expected fee income to decline mid-single digits from fourth-quarter levels due to seasonality, provision for credit losses of $50–$100 million, and noninterest expense to decline high-single digits. PNC also set a $400 million 2015 cost-savings goal, intended to support technology, infrastructure and business investment.
• PNC exceeded its 2014 continuous-improvement savings goal of $500 million. The quarterly common dividend rose from $0.44 to $0.48 in May 2014; future dividends and buybacks remain subject to Federal Reserve CCAR review. PNC repurchased $1.1 billion of shares in the last three quarters of 2014 under its approved capital plan.
• Notable items include a second-quarter correction reclassifying certain commercial facility fees from net interest income to noninterest income; a $94 million gain on sale of the Washington, D.C. headquarters building; and $209 million of gains on Visa Class B share sales. The 2013 comparison included a $53 million benefit from residential mortgage repurchase reserve releases.
• The 2014 adoption of accounting guidance for qualifying low-income housing tax-credit investments retrospectively changed expense and tax presentation; reported 2013 net income was reduced by $15 million and diluted EPS by $0.03. A new mortality assumption increased the qualified pension obligation by about $115 million; the lower year-end discount rate and revised assumptions also contributed to pension and postretirement obligation changes.
• Legal and contingent exposures include mortgage repurchase and servicing matters, interchange litigation, and other proceedings. PNC estimated reasonably possible losses of up to approximately $650 million for disclosed legal matters at year-end, but the estimate excludes some matters and is not a maximum exposure. Estimated additional residential mortgage repurchase losses above the recorded liability could be up to approximately $99 million.
• Key risks include prolonged low interest rates and margin pressure, economic or market deterioration, credit and counterparty losses, mortgage-related litigation and repurchase claims, regulatory and capital/liquidity requirements, cybersecurity and operational disruptions, and uncertainty in fair-value and credit-loss estimates.

Important facts for investors to verify

• Whether commercial loan growth and fee-income gains can offset continued margin pressure and the forecast reduction in purchase-accounting accretion.
• Credit performance and reserve adequacy, especially in home equity, residential real estate, purchased-impaired loans and consumer portfolios; note that purchased-impaired loans are excluded from reported nonperforming loans.
• How increased borrowings, liquidity buffers and new Basel III/LCR requirements affect funding costs, lending capacity and capital returns.
• The status and potential financial impact of mortgage, interchange and other legal matters, including the limits and assumptions behind disclosed loss estimates.
• Execution of the 2015 cost-savings plan, investment spending, and the Federal Reserve’s response to PNC’s 2015 capital plan.